A Traders’ “Prop 19″: Why not legalize some insider trading and leave it to corporations to police the rest?

But lawmakers ought to put an end to the party and legalize insider trading, at least in part, because it’ll make our markets work better.

Congress should also leave it up to the corporation who owns the inside information, not some bureaucrat in D.C., to decide what to protect and what not to protect.

This will free up scant resources for what really matters – preventing the next Madoff and focusing on the high-profile executives who nearly led us into financial ruin.

The Pros and Cons

On paper, insider trading law is relatively simple. If you break a promise to a company not to trade on its confidential information or you trade while knowing something you know you shouldn’t know, you are a likely criminal.

The debate on the law’s wisdom is pointedly not simple. It centers on whether insider trading harms or benefits markets.

Scholars’ arguments focus on the following pro-ban claims:

Securities professor Louis Loss has said that without a ban people will lose faith in the markets and take their money out.

That is unlikely. As Emory Law professor William Carney points out, knowing they might be dealing with insiders, investors would not refuse to buy stock. They would simply put a lower value on the stock because they know less than the insider.

Also, if ban proponents were right you’d expect stricter enforcement of the law to lead to more widespread participation in markets. That hasn’t been demonstrated, Law and Economics Professor Stanislav Dolgopolov claims in a comprehensive survey of the literature on the subject.

Insider trading benefits insiders at the expense of outsiders, such as small investors who are most in need of the laws’ protection.

Some small investors may indeed lose to an insider, but many do not, as argued by George Mason University dean emeritus Henry Manne.

Those investing long term generally do not lose. Say an insider knows something bad about a company that you don’t know and is trying to sell its stock on the public market. If you are a long term investor you wouldn’t be tempted by the slightly lower price the insider may be offering — you are not interested in short term fluctuations. If the company is fundamentally strong you ride out the storm unscathed. If it is not, you would have lost anyway because you are in it for the long haul.

Not all short term investors lose, either. If you were going to trade anyway, with or without the insider offering to sell or buy, you can now buy at a slightly lower price or sell at a slightly higher price than if there was no insider to deal with.

Insider trading raises the cost of making a trade.

That happens, some think, because market makers, specialists who constantly trade shares and thus allow small investors to trade whenever they want, consistently lose from trading with insiders because insiders know something they don’t. In order to recoup their losses, these specialists increase their bid-ask spread — the differential between buying and selling prices. Which in turn raises the price at which a small investor can buy the stock.

But if that were so the bid-ask spread would increase in markets where the risk of insider trading is higher. Such relationship has not been found.

Insider trading gives the wrong incentives to managers of corporations.

Without a ban, professor Roy Schotland has claimed, managers would just delay revealing important news so they can reap the benefits of their insider knowledge on the stock market. Managers would also purposefully engage in projects that are bad for the firm in order to profit by trading its shares, according to Judge Frank Easterbrook.

Maybe so, but University of Chicago’s Dennis Carlton and Northwestern University’s Daniel Fischel show that insider trading prods managers to produce valuable information and to take risks that increase the company’s value. Further, some argue long term shareholders should let managers make money off insider trading because this sort of manager “compensation” does not come from corporate profits and so investors get a bigger share of the company’s value.

There is no clear winner on this point and more real world tests are needed to resolve it.

Firms can raise more money cheaply in places with insider trading laws compared to places without such laws.

A study found that in most countries with insider trading laws corporations pay on average 5 percent less in order to issue shares but only if such laws are enforced. There is no discount in countries without enforcement.

But the authors themselves warn that how much a firm pays for issuing shares seems only correlated with law enforcement, not necessarily caused by it. A third factor, the overall attractiveness of a country’s market to outside investors, may well be the reason for the lower cost.

Insider Trading Spreads Information Faster

Not only are the pro-ban claims lackluster, at best, but there is also a powerful positive argument against the ban.

Most scholars agree that insider trading makes sure that capital goes to the right place quicker.

Insiders generally know more about their company than anyone else. If they know something that others don’t then the price that others attach to the company is wrong. So, when insiders trade their own company’s stock they tell the market something it doesn’t know and change the stock price to reflect the new view of a firm’s prospects.

Prices are what investors look to in determining where to invest. The quicker these prices change to reflect the true value of a firm the quicker investor money flows into the good firms and out of the bad ones.

So academics show that insider trading benefits the economy by pushing capital to the right places faster, and, even if harmful to some short-term speculators, it does help most long-term investors and lacks most of the harms imputed to it.

All or Nothing?

The academic debate is fascinating, but in the real world most governments agree: insider trading is not good for society. All developed countries, and four out of five emerging market economies, have laws against insider trading (see chart). The practice banned is not banned nearly everywhere, but banned in its entirety.

But is all insider trading really that bad?

It is important that information gets to the markets as soon as possible and insiders accomplish that by trading on their knowledge. But not all information spreading through insider trading may be good for the economy.

Some think insider trading which results in higher stock prices is bad and should be banned. A company acquires another because it believes the combined value of the firms would be greater than their separate values. This is why when the merger is announced the stock of the target usually rises. Without the ban, insiders who know of the merger early would bid up the target’s stock and make it too expensive for the acquiror to buy it. Thus the overall value that the merger would have created is destroyed.

But the rapid spreading, via inside trading, of negative news, such as a firm’s impending bankruptcy, gives valuable insight to the market quicker and preserves more overall value because investors pull their money out and put it into better companies. So professors Thomas Lambert and Donald Boudreaux think this price-decreasing insider trading should be allowed.

Who Should Police Insider Trading?

Are government bureaucrats the right watchdog here?

Generally, valuable company information belongs to the company and its investors. So, isn’t the company the natural party to decide what to guard?

If a company owns the inside information, and if insiders want to use that information because they can profit from it, why can’t the two bargain with each other and leave the government out of it?

If the company is harmed by insider trading, such as when merger value is destroyed, more than the insiders gain from engaging in such trading, the firm’s investors will not be interested in allowing such trading. Conversely, if the gains of insider trading exceed the costs to the firm, insider trading will happen because the company’s investors will be willing to sell to insiders the right to trade.

Both sides profit and the bureaucrats are out of the equation saving us precious resources that are better used for, say, Madoff-like scams.

This model may not be perfect but it needn’t be. It just needs to be a little better than a situation where any insider trading, however beneficial, is potentially criminal and is policed by elected bureaucrats with political agendas.

Who Really Benefits from the Ban on Insider Trading?

Insiders don’t — they are the ones banned from profiting, remember. Neither do individual investors much.

But broker-dealers, floor traders and institutional investors do. They don’t have quite the same access to company secrets that insiders have but are much better than individual investors at collecting and analyzing data to deduce these secrets. And with insiders out of the equation, ask professors David Haddock and Jonathan Macey, who else but these professionals is left to reap the lion’s share of trading profits.

Of course, regulation also benefits its enforcers, the SEC and others, by giving them more power, prestige, and budget.

So, not only is the ban slowing down information spreading, is needlessly overbroad and wasteful of precious enforcement resources, but it also mostly benefits sophisticated, wealthy professionals. And the bureaucrats charged with enforcing it.

It’s never been the stated goal of our securities laws to provide a benefit to either of these two. So, it shouldn’t be wrong to withdraw it, at least in part.

Or to hand enforcement of whatever laws remain to corporations so that authorities may be free to pursue the real criminals.

The markets will like the former. The public will doubtless like the latter.